Where do Stock Returns Come From? (EP.140)

Episode Summary

Executive Summary: This episode of Rational Reminder explores the anatomy of stock returns, focusing on where value and growth premiums come from. Ben and Cam analyze Fama-French papers on migration and convergence, showing that value stocks' returns historically come from convergence (improving relative prices) while growth stocks' returns come from book equity growth offset by falling valuations. Cliff Asness's recent paper argues that ignoring valuation changes misleads expectations; the value premium remains positive even after accounting for widening spreads. The episode also covers a simplified Canadian home office tax deduction and critiques a Forbes article dismissing evidence-based investing.

Main Topics: Anatomy of Stock Returns (Fama-French Migration and Anatomy Papers) (Priority: 5/5): Detailed breakdown of where stock returns come from: dividends, capital gains from growth in book equity, convergence in price-to-book ratios, and drift. For value stocks, convergence is the dominant source; for growth stocks, book equity growth is offset by negative convergence. Cliff Asness 'The Long Run is Lying to You' (Priority: 4/5): Asness shows that historical returns are heavily influenced by valuation changes. For the S&P 500, 1.3% of the 6.5% excess return from 1950-2020 came from CAPE expansion. For value, the regression intercept (valuation-adjusted premium) is 3% vs. realized 1.9%. Implications for the Value Premium (Priority: 4/5): Despite recent poor performance, the expected value premium remains positive. The value spread is at its widest since 1950. Three possible futures: spreads widen forever (unlikely), stay flat (premium ~3%), or narrow (premium >3%). Book Reviews: The Coaching Habit and Elon Musk (Priority: 2/5): Ben reviews Michael Bungay Stanier's 'The Coaching Habit' (seven key questions) and Ashley Vance's 'Elon Musk' biography, highlighting Musk's Canadian roots and relentless risk-taking. Canadian Home Office Tax Deduction (2020) (Priority: 3/5): New simplified flat-rate method: $2 per day worked from home (max 200 days) without T2200. Renters may benefit more than owners due to proportional rent deduction. Bad Advice of the Week: Forbes Article on Evidence-Based Investing (Priority: 2/5): A Forbes article criticizes evidence-based investing as backward-looking. Ben counters that dismissing a well-tested theory for a vague active management story is unscientific. Community Updates and Podcast Changes (Priority: 1/5): Listener engagement (socks, Peloton, Goodreads), upcoming interviews with Jennifer Risher and Ashley Whillans, and a new alternating format between investment and financial planning topics.

Key Arguments: Value premium historically comes from three sources: value stocks improving in type (migrating to neutral/growth), growth stocks deteriorating, and value stocks that remain value beating growth stocks that remain growth. The size premium is almost entirely due to a small fraction (8-12%) of small stocks that become big stocks. For value stocks, capital gains are driven by convergence (rising relative prices) rather than growth in book equity; for growth stocks, book equity growth is offset by falling relative prices. Historical returns are misleading if valuation changes are ignored. The S&P 500's 6.5% excess return (1950-2020) includes 1.3% from CAPE expansion; the value premium's realized 1.9% becomes a statistically significant 3% after adjusting for value spread changes. The wide value spread today does not necessarily imply mean reversion, but even if spreads stay flat, the expected value premium is positive (~3%). Evidence-based investing is not about blindly extrapolating past returns; it's about using scientific methods to test theories, which active management fails to do consistently.

Data Points: Small value total return (1927-2006): 14.44% - From Fama-French anatomy paper; big growth was 9.18%. Convergence contribution to small value capital gains: 13.45% per year - Main driver of small value returns; book equity growth was negative. Growth in book equity contribution to big growth capital gains: 10.3% per year - But convergence subtracted 5.38% per year, netting 5.8% capital gain. S&P 500 excess return (1950-2020): 6.5% - Regression intercept (unexplained by valuation) was 5.2%; valuation change (CAPE from 10.9 to 34.5) contributed 1.3%. HML Devil value premium (1950-2020): 1.9% (statistically insignificant) - Regression intercept (valuation-adjusted) was 3% (statistically significant). Value spread in December 2020: Widest since 1950 - From Cliff Asness paper; chart included in episode. Percentage of small stocks that become big (size premium source): 8-12% - These stocks explain almost all of the size premium from 1927-2006. Canadian home office deduction flat rate: $2 per day, max 200 days - Simplified method for 2020; no T2200 required.

Pivotal Quotes: "The long run is lying to you. If you're not accounting for valuation changes over the time period that you're examining, you're missing a big piece of what drove returns that's unrelated to forming expectations about the future." — Benjamin Felix (paraphrasing Cliff Asness): Introducing Cliff Asness's paper and its core message about historical returns being misleading. "Value stocks that remain value stocks beat growth stocks that remain growth stocks. That is so interesting." — Benjamin Felix: Discussing the Fama-French migration paper finding that even without migration, value outperforms growth. "The recent terrible returns to value don't mean the long-term expectation for value is much, much lower." — Benjamin Felix (paraphrasing Cliff Asness): Summarizing the implication of Asness's regression analysis for the value premium outlook.

Implications: Investors should not extrapolate recent poor value performance; the expected value premium remains positive (~3% even without convergence). Valuation changes significantly distort historical returns, so forward-looking expectations must account for current spreads. The simplified Canadian home office deduction offers an easy tax break for eligible employees. Evidence-based investing remains a robust framework despite critiques.